Understanding 2013's fiscal cliff

In the first two days of 2013, large tax cuts will expire and across-the-board cuts to defense and nondefense programs will begin a drastic hit to the economy — a so-called fiscal cliff — that both parties say could be damaging to the unsteady recovery. Here is a primer on the tax increases and program cuts and their potential impact on the economy.

Almost everyone who pays taxes would see a hit to take-home pay in the first paycheck of January.

• The lowest income tax rate would rise to 15 percent from 10 percent. The highest rate would rise to 39.6 percent from 35 percent. The 25, 28 and 33 percent rates would rise to 28, 31 and 36 percent, respectively.

• Most capital gains taxes would rise to 20 percent from 15 percent. The tax rate on dividends, now set at 15 percent, would jump to ordinary income tax rates. And because most dividend taxes are paid by the wealthy, that would mean a new dividend tax rate of 39.6 percent.

• The exemption on taxation of inherited estates would drop to $1 million from $5 million. The tax rate above that exemption would jump to 55 percent from 35 percent.

Even many of the working poor who do not earn enough to face such taxes would take a hit when a temporary, 2-percentage-point cut to the payroll tax that funds Social Security and Medicare expires on Jan. 1.

In all, taxes would rise by as much as $6 trillion over 10 years, $347 billion in 2013 alone, if the Bush-era tax cuts expire along with the payroll tax cut, and Congress fails to deal with the expanding alternative minimum tax, according to the Congressional Budget Office and Decision Economics Inc., a private economic forecaster.

What about the spending cuts?

Most defense programs would be sliced by 9.4 percent. Most nondefense programs outside the big entitlements— Social Security, Medicare and Medicaid — would be cut by 8.2 percent. Medicare would be trimmed by 2 percent.

Social Security, veterans benefits, military personnel, Medicaid and the Children's Health Insurance Program would be exempt.

What about the economic impact?

If nothing is done, the increases and spending cuts would send the economy back into recession. The 2013 impact alone — about $600 billion in tax increases and spending cuts — exceeds the projected growth of the gross domestic product. The Bipartisan Policy Center estimates that the cuts — called sequestration — could cost 1 million jobs in 2013 and 2014.

The Congressional Budget Office projected that real economic growth would decline at an annual rate of 2.9 percent during the first half of 2013. Unemployment would rise to 9.1 percent by the end of next year.

How did we get here?

President George W. Bush and Republicans in Congress could not muster the 60 votes in the Senate to pass Bush's initial 10-year, $1.7 trillion tax cut in 2001, so they used a parliamentary tool called reconciliation to pass the tax cuts with a simple Senate majority of 51 votes. The catch was that this meant the tax cuts would expire after the 10-year budget window closed in 2011. In 2003, when Bush went back for another round of tax cuts, Republicans in Congress again used reconciliation to avoid a Democratic filibuster and maximized the initial size of the tax cuts by having them expire at the same time as the first tax cuts, in 2011.

After the 2010 elections, President Obama struck a deal with Republicans to extend the tax cuts for another two years, as well as add other tax measures, like the payroll tax cut, to help the economy. Now that extension is ending.

The across-the-board cuts are more complicated. The newly elected Republican House in 2011 refused to raise the debt ceiling, the nation's statutory borrowing limit, without legislation guaranteeing that the increase would be at least matched by deficit reduction. Congress and the White House agreed to spending caps that shaved about $1 trillion off projected growth over 10 years. They also created a special, bipartisan deficit reduction committee to find another $1.2 trillion in savings over 10 years. If that effort failed, savings would be guaranteed by automatic cuts to defense and nondefense programs beginning in 2013. The so-called super committee failed, and the government is now staring at the consequences.

How do we get out of it?

Some fledgling bipartisan talks have begun. The so-called Gang of Six senators are trying to negotiate a framework moving forward that would set up a deficit- reduction outline, instruct congressional committees to make it real in six months, then punt the spending cuts and tax increases into next year.

Most of these negotiations accept that savings would have to come from entitlement programs like Social Security and Medicare, and an overhaul of the tax code that raises revenue by closing loopholes and curtails or ends tax deductions and credits. Most Republicans and some Democrats say they can generate additional revenue that way and still lower tax rates across the board.

Where is President Obama on all of this?

He has previously said he will not sign any bill that extends the tax cuts for the rich but wants legislation that extends the tax cuts for families earning $250,000 or less. That alone would be enough to mitigate the economic impact of the fiscal cliff.

He also opposes across-the-board spending cuts, but says there should be no "easy off-ramp," that is, he will not sign legislation simply canceling the cuts unless Congress comes up with a plan for deficit reduction at least equal to $1.2 trillion. Obama has signaled he will accept changes to Social Security, Medicare and Medicaid as part of a overall solution.